Episode 25: Cash Flow vs. Appreciation – Understanding Return Profiles with Tax Pro Tina

Welcome to Building Passive Income, the podcast for professionals, entrepreneurs and investors who want to build wealth, diversify beyond Wall street, and create true financial freedom through passive commercial real estate investing. I'm Wayne Courageous III, founding and managing principal of Crei Partners, a leading commercial real estate company. I created CreiColin, an AI powered resource to serve as your investor education guide. Built on the insights and experience we've developed at Crei Partners, CreiCollen is here to educate you through passive invest tax strategy topics to help your journey in passive investing. Just a quick disclaimer. This podcast and CRA Colin is for educational purposes only and is not legal tax or investment advice. Always consult with your attorney, CPA and financial advisor before making any investment decisions. I've spent nearly two decades helping investors understand the power of commercial real estate, from multifamily to storage to retail. Each episode is under 15 minutes, simple to follow and and packed with insights to help you grow your income and protect your capital without becoming a landlord. If you're ready to learn quickly and invest smarter, you're in the right place. Welcome to Building Passive Income. Let's build wealth together. Here's creicollen.

When you're evaluating a syndication deal, you'll see two types of cash flow and appreciation. Some deals are cash flow heavy. They often distribute early in the hold period, but the exit might be modest. Other deals are appreciation heavy. You get little to no cash flow for years, but the exit is massive. So which one is better? I'm Crei Collin and this is Building Passive Income where we give you the strategies to build real wealth through through passive real estate investing. The truth is there's no one size fits all answer. It depends on your goals, your timeline, and this is important, your tax situation. Because cash flow and appreciation are taxed differently, they have different risk profiles and they serve different purposes in your portfolio. Today we're bringing back TaxPro Tina to break down cash flow versus appreciation, how to evaluate return profiles, how to understand the tax implications, and how to build a portfolio that balances both strategies. Let's dive in.

Colin, Great to be back. And yes, this is one of the most important topics for passive investors because most people focus only on total return without understanding how that return is generated or how it's taxed.

So let's start with the basics. What's the difference between cash flow and appreciation in a syndication deal?

Great question. Let's define both. Cash flow is the money you receive during the hold period, quarterly or annual distributions. This is income generated by the property's operations. Rent comes in, expenses go out, debt service is paid, and whatever's left is distributed to investors. Appreciation is the increase in property value over time. You realize appreciation when the property is sold. If the sponsor bought the property for $10 million and sold it for 15 million, that 5 million gain is appreciation. And after the lender is paid off and the sponsor takes their share, the remaining profit is distributed to investors. Now here's what most investors don't understand. Every syndication deal has both cash flow and appreciation. But the balance between the two varies dramatically depending on the business plan. Some deals are cash flow focused. They're stabilized properties with high occupancy and often distribute early in the hold period, sometimes starting in the first or second quarter. You might get a 7 to 9% cash on cash return every year, but the appreciation at exit might be modest, say a 1.3 to 1.5x equity multiple. Other deals are appreciation focused. They're heavy value add or development deals. You might receive little to no cash flow for the first two to three years, but the exit could deliver a 2 to 3x equity multiple. And then there are balance deals, moderate cash flow during the hold period and solid appreciation at exit. These typically target a 1.8 to 2.0x equity multiple with 6 to 8% annual cash on cash return.

Okay, so how do you evaluate which type of deal is right for you?

It all comes down to your goals in your timeline. If you need income now, maybe you're retired or you're building passive income to replace your salary. You should prioritize cash flow focused deals. You want properties that are already stabilized and distributing money early in the hold period. If you're in wealth accumulation mode, you don't need income now. You're reinvesting everything and you're focused on building long term wealth. You can handle appreciation focused deals. You're willing to wait three to five years for the big payout at Exit. And if you want balance some income along the way plus solid appreciation, you should focus on value add deals that distribute cash flow starting in year two and deliver strong appreciation at exit. Here's an example. Let's say you invest $50,000 in two different deals. Deal A is a stabilized core plus property. It distributes $4,000 per year in cash flow, 8% cash on cash. You hold for five years and receive $20,000 in total distributions at exit. The property sells for a modest gain and you get your 50,000 back plus another 10,000 in profit. Total $80,000. That's a 1.6x equity multiple and about a 12% IRR. Deal B is a heavy value add deal. It distributes zero cash flow in year one, 1,000 in year two, 2,000 in year three, and 3,000 in years four and five. Total distributions over five years, $9,000. But at exit, the property sells for a massive gain and you receive your 50,000 back plus 60,000 in profit. Total $119,000. That's a 2.4x equity multiple and about 19% IRR. Same $50,000 investment, same 5 year hold. But very different cash flow profiles and return structures. Which one is better? It depends on your goals. If you need income now, Deal A is better. If you're building long term wealth and don't need income, Deal B is better.

That makes sense. Now let's talk about taxes. How are cash flow and appreciation taxed differently?

This is where it gets interesting and where most investors don't get the full picture. Let's start with cash flow. The K1. Income from operations is generally passive for most investors. And depreciation often reduces taxable income even when cash is distributed. So even though you're receiving say $4,000 in cash flow, your K1 might show a passive loss of $10,000. That loss can offset other passive income you have, like cash flow from other syndications. And if you don't have enough passive income to use the loss, it carries forward until you do. This is why cash flow from syndications is often tax sheltered or or tax deferred depending on depreciation in your situation, because the depreciation deductions can shelter the income. Now let's talk about appreciation. When the property is sold, the gain is split into two depreciation recapture and capital gains. Depreciation recapture is generally taxed at higher rates than capital gains, often up to 25% for unrecaptured section 1250 gain, which is with some components, potentially at ordinary rates depending on the asset. This applies to the depreciation deductions you've been taking over the years. Capital gains, the appreciation above and beyond depreciation recapture are taxed at long term capital gains rates, which for most high income earners is 15 or 20% plus the 3.8% net investment income tax. So appreciation is taxed at exit but at preferential rates compared to ordinary income. Here's the key takeaway. Cash flow is often sheltered by depreciation during the hold period, so it's often tax sheltered or tax deferred. Appreciation is taxed at exit but at capital gains rates which are lower than Ordinary income rates. Both are tax efficient but in different ways.

Okay, so if I'm a high income earner trying to reduce my taxable income, which strategy should I focus on, cash flow or appreciation?

Great question, and this is where strategy really matters. If your primary goal is to reduce your taxable income through passive losses, you should focus on value add deals with cost segregation studies. These deals can generate significant first year passive losses, sometimes substantial relative to your investment, depending on cost segregation, bonus depreciation and timing. Those passive losses typically carry forward to offset future passive income and may be released when you fully dispose of the activity, subject to IRS rules. If you don't have enough passive income this year, the losses carry forward and can be used in future years to offset passive income or in certain situations when you dispose of the investment. Now here's the nuance. Some stabilized deals may produce smaller first year deductions than heavy value add deals, but it depends on cost segregation, asset components and tax timing. You'll still get some depreciation to shelter the cash flow, but the passive losses won't be as large. Appreciation deals, especially heavy value add or development deals, can generate large passive losses because the sponsor is investing heavily in capital improvements and those improvements may be depreciated rapidly through cost segregation. So if your goal is tax reduction, focus on appreciation heavy value add deals with cost segregation. If your goal is immediate income, focus on cash flow deals, but understand that the tax benefits will be more modest.

What about the exit? Are there strategies to defer taxes on appreciation when the property is sold?

Absolutely. The two most common strategies are the 1031 exchange and investing through a self directed retirement account. Let's start with a 1031 exchange. A 1031 exchange can defer gain on qualifying real property exchanges, but many syndications do not allow LP interest to 1031 directly. So you need to plan ahead and confirm what options exist. We covered this in detail in episode 17, but here's the quick summary. You have 45 days to identify a replacement property and 180 days to close. If you follow the rules, you can defer all taxes and keep your capital working for you. The challenge is that not all syndication sponsors are offer structures that allow for 1031 exchanges. You need to plan ahead, confirm your options and work with a qualified intermediary. And you need to have a replacement property lined up. The second strategy is investing through a self directed ira or Solo 401k. If you invest through a retirement account, all cash flow and appreciation grow tax deferred or tax free. If It's a Roth account depending on structure and any UBIT considerations. The downside is that you can't use the depreciation deductions to offset other income because those deductions are trapped inside the retirement account. This strategy works well for investors who are maxing out their retirement contributions and want to invest in syndications with tax advantaged dollars. But it's not ideal for high income earners who need passive losses to offset other income.

Alright, let's talk about portfolio construction. How should investors balance cash flow and appreciation in their portfolio?

This is where most investors get it wrong. They go all in on one strategy without thinking about balance. Here's my Build a portfolio that includes both cash flow and appreciation based on your stage of life and your goals. If you're in accumulation mode, you're working, you have high income and you don't need cash flow. Allocate 70 to 80% to value add deals focused on appreciation and tax benefits and 20 to 30% to cash flow deals for stability. If you're in transition mode, you're a few years from retirement and starting to think about income. Allocate 50 50. Half your portfolio is generating cash flow and half is building long term wealth through appreciation. If you're in retirement or financial independence mode, you need income now. Allocate 70 to 80% to cash flow focused deals and 20 to 30% to appreciation deals for continued growth. The key is to match your portfolio to your life stage. And remember, you can always adjust over time. As you move closer to retirement, you gradually shift from appreciation heavy deals to cash flow heavy deals.

Last question. What's the biggest mistake you see investors make when it comes to cash flow versus appreciation?

The biggest mistake is chasing total return without understanding how that return is generated. I see investors get excited about a deal projecting a 25% IRR, but they don't realize that 100% of that return comes from appreciation. At exit with zero cash flow for three years, then year three hits, the market softens and the exit doesn't happen. They're stuck with no income and no liquidity. Or I see investors focus only on cash flow and invest in stabilized deals with 7% cash on cash returns. But they miss out on the wealth building power of appreciation and depreciation. They're generating income, but they're not building long term wealth. Here's my advice. Don't invest in any deal until you understand the return profile. Ask yourself how much of the projected return comes from cash flow and how much comes from appreciation. Am I comfortable with that? Balance and does it align with my goals? And remember, diversify. Some deals should be cash flow focused, some should be appreciation focused and some should be balanced. That way you're not overly dependent on one strategy.

Alright, let's recap. Cash flow and appreciation are both important components of syndication returns, but they serve different purposes and are taxed differently. Here's what you need to know. 1. Cash flow is income you receive during the hold period. It's often tax sheltered or tax deferred depending on depreciation and your situation. 2. Appreciation is the increase in property value realized at exit Depreciation recapture is generally taxed at higher rates than capital gains, often up to 25% for unrecaptured 1250 gain with some components potentially at ordinary rates. Capital gains are taxed at preferential rates. 3. Cash flow focused deals are great for investors who need income now. Appreciation focused deals are great for investors building long term wealth. 4. High income earners should focus on value add deals with cost segregation for significant passive losses depending on timing and tax rules. 5. Use 1031 exchanges or self directed retirement accounts to defer taxes on appreciation, but confirm your options as many syndications don't allow LP interest to 1031 directly. 6. Balance your portfolio based on your life stage. More appreciation in accumulation mode, more cash flow in retirement mode. 7. Don't chase total return without understanding the return profile. Know how much comes from cash flow and how much comes from appreciation. Here's your action. Review your current syndication investments for each deal. Identify how much of the projected return comes from cash flow versus appreciation. Make sure your portfolio balance aligns with your goals. If it doesn't, adjust your strategy going forward. And as always, Tina's sign off. Remember, always consult your CPA or tax advisor. But now you know the right questions to ask if you're ready to build a tax efficient syndication portfolio that balances cash flow and appreciation. Let's talk. Check the show notes for a link to schedule a call with us@creipartners.com next week on Building Passive Income, we're diving into understanding equity waterfalls, how profits are split between GPs and LPs, and why this is one of the most important sections of the ppm. Until then, remember, financial freedom isn't a dream, it's a decision. And it starts with understanding how your returns are generated and taxed. I'm Crei Colin let's build wealth together.

Thanks for tuning in to Building Passive Income. Today's episode helped shift your mindset or gave you a new tool to to grow your wealth. Do us a favor and like, subscribe and share this podcast with someone you care about. Want to go deeper? Join our free Passive Investor coaching program@ passiveinvestorcoaching.com it's the perfect next step to start building wealth through commercial real estate the right way. Remember, financial freedom isn't a dream, it's a decision. And it starts with building passive income. We'll see you in the next episode.

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